U.S. Housing Overview
The continued conservatorship of Fannie Mae and Freddie Mac exposes taxpayers to continued risk.   The failure to address the GSEs and release them from the conservatorship evidences a significant failure of political will.
This chart from the latest monthly report from the Housing Finance Policy Center at the Urban Institute provides a fine summary of the government dominance of U.S. residential housing finance. This imbalance with private sector financing is imposing significant risk on the GSEs and therefore on the government and taxpayers without analysis or justification. There should be a fundamental analysis of the government’s housing policy and how much risk needs to be taken by the taxpayers in order to achieve the government’s goals.
Regulation AB II and Canadian Covered Bonds — the end of SEC registered covered bonds?
The recent amendments to Regulation AB (commonly referred to as “Reg AB II”) were a policy response to the perceived inadequacy of securitization disclosure prior to the financial crisis and a response to a request by very large investors for extensive, detailed information about the assets in a securitization. The adoption of the changes to Regulation AB was only possible after the SEC negotiated protection from the Consumer Financial Protection Bureau (the “CFPB”) for issuers filing the data required by the SEC. The CFPB statement provides that an issuer filing data in accordance with the SEC rules will not be in violation of the financial privacy laws.
The result of the amendment is a package of regulations that call for the disclosure of loan-level data that varies by asset class. In the case of assets that are residential mortgage loans, the rules call for the disclosure of 272 data fields for each mortgage loan, including the first two digits of the postal zip code for the property.
In a study conducted by the SEC staff prior to the adoption of the amendments, the staff calculated that disclosure of the full five digit postal zip code for a property would result in an 80% likelihood that the identity of the borrower would be discernable. With the reduction to disclosure of only the first two digits of the postal zip code, the staff concluded that there was still a 20% likelihood that a borrower could be identified. Thus the need for the SEC to obtain CFPB protection for issuers.
But what has this to do with covered bonds? After all, covered bonds are not securitizations, but rather special form of secured debt. The answer is somewhat complex.
OSFI to Reconsider 4% Limit?
According to reports in The Cover and The Covered Bond Report, Canada is considering whether to increase the 4% limit imposed on covered bond issuance. This limit was imposed by the Office of the Superintendent of Financial Institutions (OSFI) at the inception of covered bond issuance by Canadian banks in 2007 and remains unchanged today. While the limit is the most stringent currently applied in the covered bond world, Canadian banks have nevertheless been active issuers of covered bonds as can be seen by the table below.
| US$ | EUR | GBP | CHF | A$ | C$ | |
|---|---|---|---|---|---|---|
| Issued (mm)* | 71,600 | 44,037 | 4,375 | 2,075 | 7,450 | 4900 |
| Outstanding (mm)* | 39,600 | 38,613 | 4,375 | 1,400 | 5,100 | 3,300 |
Source: www.us-covered-bonds.com/cdn_issue_details
* As of January 28, 2016.
The current 4% limit is measured as the Canadian dollar equivalent amount of covered bonds outstanding divided by total assets. The table below shows the covered bond issuance capacity remaining for each Canadian covered bond issuer as of December 2015.
| BMO | BNS | CCDQ* | CIBC | NBC | RBC | TD | TOTAL | |
|---|---|---|---|---|---|---|---|---|
| Total Assets (mm)** | 641,881 | 856,497 | 1,318 | 463,309 | 216,090 | 1,074,208 | 862,532 | 4,115,835 |
| Maximum Amount (mm) | 26,100 | 33,600 | 7,400 | 18,200 | 8,300 | 43,500 | 42,400 | 179,700 |
| Outstanding Amount (mm) | 11,600 | 22,200 | 5,400 | 10,700 | 7,300 | 31,300 | 20,900 | 109,400 |
| Used Capacity | 44.3% | 66.0% | 73.1%* | 59.0% | 87.8% | 71.6% | 60.9% | 60.9% |
| Remaining Amount (mm) | 14,500 | 11,400 | 2,000 | 7,500 | 1,000 | 12,400 | 21,500 | 70,300 |
Source: CMHC, Covered Bond Business Supplement, September 2015.
*Note that CCDQ is subject to a different limit, which is set by Autorité des marchés financiers at EUR 5.0 billion.
** As of October 31, 2015.
The Volcker Rule and Covered Bonds
The Volcker Rule became effective on July 21, 2015. There are two aspects to the Volcker Rule: a prohibition on proprietary trading and a limitation on sponsoring or investing in a ‘covered fund.’ It is this second aspect of the Volcker Rule that concerns investors in covered bonds. The Volcker Rule applies to banks in the United States, including the branches, subsidiaries and affiliates of foreign banks. Even if the investor in a covered bond is not a bank subject to the Volcker Rule, if investment in the covered bonds is subject to the Volcker Rule,the secondary market liquidity for the covered bond can be adversely affected.
If the prospectus for the covered bond does not disclose whether an investment in the covered bond is limited under the Volcker Rule, how can you determine whether the Volcker Rule applies? This can be quite a complex analysis. Fortunately, Morrison & Foerster has written a helpful article on analyzing whether a covered bond is subject to the Volcker Rule. See A user’s guide to Volcker Rule complexities.
Why is CB legislation tied to GSE reform?
Why is the adoption of covered bond legislation linked to housing finance reform? Housing finance reform is all about the role of the GSEs. While covered bonds certainly can be used to finance residential mortgage loans, they do not require any form of government support. The consideration of the proper role of the government in housing finance can occur independent of covered bonds. However, I hear from many sources that covered bond legislation would only be considered after GSE reform had been adopted or perhaps considered with GSE reform.
There is no apparent logic to this position. Covered bonds are a private sector financing technique that has proved very effective in other jurisdictions. There is nothing in GSE reform that would be a necessary predicate to the issuance of covered bonds by U.S. banks. Covered bond legislation would not touch the status of the GSEs. It is possible that covered bond issuance by U.S. banks could develop into an attractive alternative to financing through the GSE and thus reduce the tension in GSE reform, but that would be beneficial to GSE reform.
It seems as though both sides are determined to keep as much pressure on GSE reform as possible in order to achieve their objectives and not permit any private sector initiatives to sidetrack the discussion until the role of the government in housing finance has been solved. But this seems to put the cart before the horse. Shouldn’t the government intervene only where the private sector is not functioning properly? Wouldn’t it make sense to let private sector initiatives develop first before assigning the government a role? If we can agree that the answer to those two questions is yes, why not adopt covered bond legislation and see how the market develops while we debate how to wind down the GSEs and what would be the appropriate future structure for the government’s role in housing finance?
Certainly we can have a fulsome debate on how the government can support housing access for those who need assistance independent of how covered bond legislation is drafted. Certainly if covered bonds, RMBS and the federal home loan banks fail to provide adequate private sector funding for residential mortgage loans there may be a need to consider a larger government role.
It is not essential that covered bonds be enabled through legislation as it is possible to achieve covered bond issuance through securitization techniques, as has been done in other countries. See, e.g., Time for a US alternative. However, investors will have more confidence in a covered bond sector established through legislation and the market may be expected to develop quicker with legislation. Enacting legislation for covered bonds would be a low cost experiment that would have no harmful side effects. Covered bond legislation, therefor, should be enacted before GSE reform is attempted so that we have a better chance to assess what works in the private sector before designing the government’s role in housing finance.
Why do investors like covered bonds?
Why do investors like covered bonds?
What is it about covered bonds that investors like? Even U.S. investors who have plenty of other fixed income investment opportunities. In Europe there is more than €2 trillion in covered bonds outstanding. Even in the U.S., which has no statute to enable its banks to issue covered bonds, there is $150 billion of covered bonds outstanding.
What is it about these bonds and who is buying them?
You can find out who the investors are at The Cover or The Covered Bond Report. Both publications provide a breakdown of type and location of investors by offering. And what the data shows is that banks and central banks are between 50% and 80% of the investors, depending on the offering. The remainder goes to funds, asset managers and insurance companies. While not a distinct class of investors, the composition is quite different from the class of investors in bank senior debt or securitizations. Why? And why central banks? Aside from QE, of course.
The answer lies in the nature of covered bonds. Covered bonds are a different kind of investment. They are more than senior bank debt because there is recourse to the cover pool. They are more than securitization because there is recourse to the issuing bank. Covered bonds are a dual recourse instrument, which raises an investor’s confidence in their safety. Importantly, in Europe covered bonds are not subject to bail-in, while senior debt is.
And in Europe, covered bonds receive favorable capital treatment under the bank capital rules, attracting only half the capital that a senior bond from the same institution would attract. But that only makes sense given the dual recourse nature of covered bonds compared to senior debt. And of course central banks are not subject to the capital rules anyway.
So what appears to attract banks and central banks and other investors is the high level of safety with covered bonds combined with a yield that exceeds similarly rated sovereign debt. And covered bonds have a similar risk profile – no defaults in 250 years. Quite a record.
There are other details about covered bonds that are also considered important.
Covered bonds are issued by regulated financial institutions and the covered bond programs of the institutions are separately regulated.
The quality of the assets in a cover pool is high and subject to regulation. Any assets that default or become delinquent must be replaced on a monthly basis. The bank has 100% “skin-in-the-game.”
The bonds are simple, bullet pay instruments with either a fixed or floating rate. If the issuing bank were to become insolvent, the assets in the cover pool are intended to continue payments on the bonds through their maturity. No pre-payment risk.
Each series of covered bonds is a single class, so there is no complex class structure and complex payment waterfall to analyze. The credit analysis is primarily an analysis of the strength of the issuing bank and for this there is a huge community of analysts to assist an investor and a wealth of analytical experience covering more than 100 years of corporate credit analysis. The lack of experience and analytical talent was one of the prime failings of securitizations leading up to the crisis.
So what’s not to like? A risk profile like sovereign bonds and a better yield. No wonder there is a €2 trillion market. But will the United States Congress like them?
Why not covered bonds?
Why not covered bonds?
Why not pass legislation for covered bonds in the United States? It is easy to do and there is basically no cost to the Treasury. In 2011, covered bond legislation passed the House Financial Services Committee by a vote of 44 to 7, a very strong bi-partisan vote. The only dissenters were hoping to implement provisions requested by the FDIC that were rejected by the majority. The dissenters were unable to retain even members from their own party on the final vote. Probably more than any other development, this demonstrates that covered bonds are not a partisan concept, they are not divisive and they have broad support.
Covered bonds will bring private funding to residential mortgage loans, but there is no good reason that passage of covered bond legislation should be tied to GSE reform. There is nothing about covered bonds that would implicate GSE reform, except that by bringing private funding to the market they could reduce the dominate role of the GSEs. And there is no credible evidence that either party in Congress believes that a continued dominate role for the GSEs is a policy mandate.
An unlike securitization of residential mortgage loans, no concerted effort is needed to get investors to participate. Investors are wary of residential mortgage securitization as a result of the financial crisis, which was precipitated by mortgage securitization. There are many efforts underway to convince investors to return to the RMBS market. Covered bonds carry no such baggage. Covered bonds have been readily sold to U.S. markets since 2010 and investors remain eager for more.
Covered bonds are more transparent to regulators.
Covered bonds are a simpler investment analysis for investors.
Covered bonds are proven financing technology with worldwide acceptance.
Covered bonds are friendlier to mortgage borrowers because the originator retains the right to modify loans to assist borrowers in working out difficult loans.
What’s to lose? Maybe covered bonds could develop into a vibrant private sector funding alternative for residential mortgage loans. If not, no loss. And no cost. But if it works, it’s a plus all around.
Reg AB II and Covered Bonds
Updated: 12/28/2015
The United States Securities and Exchange Commission (the “SEC”) adopted revisions to Regulation AB on August 27, 2014, after a four year process of proposals and review. Regulation AB is the rule that governs the offering disclosure and periodic reporting obligations of issuers of asset-backed securities (“ABS”).
Insofar as covered bonds are concerned, several things are clear. First, covered bonds are not included in the definition of “asset-backed security.” Item 1101 of Regulation AB provides that:
Asset-backed security means a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to the security holders; provided that in the case of financial assets that are leases, those assets may convert to cash partially by the cash proceeds from the disposition of the physical property underlying such leases.
It is clear that covered bonds are not “primarily serviced by the cash flows of a discrete pool of receivables or other financial assets.” Instead, covered bonds are senior obligations of the issuing financial institution and are expected to be repaid from the general funds of the institution. Accordingly, covered bonds should not be asset-backed securities and Regulation AB should not apply generally to covered bonds.
Use CBs to Restart the PLS Market
In the United States there is a lot of discussion about how to reduce the taxpayers’ exposure to housing finance. The conservatorships of Fannie Mae and Freddie Mac were a pointed reminder of the extent of the government’s, and the taxpayers’, role in housing finance. Additionally, after being taken into conservatorship, the GSEs were intentionally used to prevent a feared collapse of the housing market, further expanding their role.
As a result, the GSEs, together with FHA and GNMA, at one point provided more than 95% of the financing for new residential mortgage loans, and today they still finance roughly nine out of every ten new mortgage loans. At the same time, the private label securities (PLS) market, which provided significant private funding for residential mortgage loans, essentially vanished. The issuance of new PLS declined nearly 99% in the years following the crisis.
Today there is general agreement across the political spectrum that it would be desirable to restore some level of private funding for residential mortgage loans and reduce the role of the GSEs. There are also plans to reform the GSEs and refine their mission in housing finance. There is less agreement on the reform proposals.
On June 27, 2014, Treasury Secretary Jacob Lew requested comment on what steps could be take to restore a functioning PLS market. Almost uniformly the commenters voiced the need to shrink the presence of Fannie and Freddie in the market in order to make room for a PLS market. This reflected the view that under the existing authority of the GSEs, the private market would not be price competitive and would only be able to finance a small number of loans that did not qualify for financing through the GSEs under their very high loan limits.
However, the presence of the GSEs is not the only factor impeding the development of the PLS market. The regulatory landscape for securitizing mortgage loans has been altered dramatically since the crisis. Basel III imposes heavy, in some cases almost punitive, increased capital requirements on banks and most particularly for securitization exposures held by banks. The risk weighting for securitization exposures can range up to 1250% and in some cases, such as non-cash gain on sale, the capital requirements will result in a deduction from Tier 1 equity capital. Rulemaking by the Consumer Financial Protection Board exposes any holder of a mortgage loans to severe penalties for those loans not underwritten in accordance with the CFPB underwriting criteria, which are designed to protect the borrower. SEC requirements for mortgage securitization require 270 data points of information to be disclosed for every mortgage loan in a securitization, both at the time of the offering and in periodic reporting for the life of the securitization. Then there is risk retention, prohibited conflicts of interest, margin requirements for swaps, the Volcker Rule, conflicting requirements in foreign securities markets and a litany of other burdens on the PLS market.
SEC Finalizes Reg AB II
On Wednesday, August 27, 2014, the United States Securities and Exchange Commission finalized the changes to Regulation AB (commonly referred to as Reg AB II). The Commission issued a press release and a draft adopting release adopting the changes. The final version of the adopting release will be published in the Federal Register after review by the Office of Management and Budget (OMB). Regulation AB II and the related changes regulate the offering process and the disclosure and reporting requirements for asset-backed securities. Perhaps the most significant changes are (i) a requirement to file a preliminary prospectus at least three days prior to the sale of any securities and (ii) disclosure of loan-level information in machine readable form for ABS backed by residential mortgage loans, commercial mortgage loans, auto loans, auto leases, and debt securities (including resecuritizations). Updated loan-level data also must be filed periodically after issuance of the securities. The loan-level disclosure requirements come into force not later than two years after the effective date of the changes, which will be the date of the publication of the changes in the Federal Register.
The effect on covered bond issuers of these changes is still being analyzed and will be covered by a later post. However, it is clear that these changes would not be directly applicable to Rule 144A offerings of covered bonds.
See the MoFo Client Alert.